Investors are glum about the prospects for the UK economy. Far too glum, says Max King. Buy in now and you’ll make a tidy return.
At a JP Morgan Cazenove investment conference I attended in February, the audience was asked which part of the world they favoured most for equity investment. The most popular choice was “emerging markets”. The least popular? The UK. After a year in which the FTSE All-Share index had underperformed the MSCI All Countries World index yet again – this time by a huge 12% – not one of the several hundred industry professionals present voted to back the British market.
Looking at its history, that’s perhaps not surprising. For the first few years after its creation in 1984, the FTSE 100 index moved in tandem with the US market at a numerical level roughly 10% below that of the Dow Jones Industrial Average (the FTSE 100 launched in January 1984 at 1,000, and the Dow spent most of the first half of that year meandering around 1,100). Had that relationship continued until today, the FTSE 100 would now be above 18,000. That’s more than 10,000 points above its actual current level. These days, the S&P 500 index is more commonly used as a reference point for US markets. Yet it too has far outperformed the UK’s headline index. The S&P is now a full 50% above its 31 December 1999 value, whereas the FTSE 100 only broke decisively above 7,000 – barely higher than it was at the end of 1999 – earlier this year.
Must try harder
What’s gone wrong for the UK market? There is no single, easy answer. The last 20 years have brought two of the biggest four bear markets seen in global stockmarkets since 1900, but US investors have seen these drops as opportunities to invest cheaply, while UK investors have disengaged from markets. Regulators, advisers and much of the fund management industry has come to equate short-term volatility with long-term risk. As a result, investors, and the pension funds they hold, have been pushed into “low-risk” bonds (which are still trading near all-time price highs, but are on the long road downwards) and “absolute-return” funds, which offer dismal returns but, hopefully, little risk of serious short-term losses. Where there is a choice, as on the new online “robo-adviser” platforms, investors are invited to choose a level of “risk” (a term that is not defined) that they are happy with (naturally, they choose “low”) without any explanation of the impact of their choice on returns.
Not only have UK investors moved out of equities, they have also diversified internationally. Before the abolition of exchange controls in 1979, investing overseas was tricky and expensive. In the 1980s and 1990s, UK investors maintained a high exposure (commonly more than 50%) to the UK, attracted by the dividend income on offer; to limit perceived exchange-rate risk; and because the market was performing well. But in the 2000s, it became rather fuddy-duddy to stick with the UK. The market underperformed and the shift out of UK equities exacerbated this weakness.
For example, Foreign & Colonial Investment Trust – the oldest investment trust in the world – now has less than 10% of its assets invested in the UK, but still has a 40% UK weighting in its benchmark. Meanwhile, overseas investors weren’t buying the UK because the quality of larger companies here had deteriorated. A frenzy of mergers in the late 1990s created, at best, unwieldy mega-caps. At worst, once-sound companies such as industrial giants GEC and BTR were destroyed. Investors, keen to reduce UK exposure, were all too willing to sell quality companies for short-term gain. It seemed that, at last, lessons had been learned from Kraft’s controversial purchase of Cadbury in 2010 – until SoftBank pounced on ARM last year.
The FTSE 100 that was left behind was dominated by mega-caps such as HSBC, Shell, GlaxoSmithKline, Vodafone and Marks & Spencer, whose share prices stagnated while the chief executives’ remuneration multiplied. The food retailers over-expanded, the banks imploded, and the resource companies invested on the basis of permanently high commodity prices. The route to higher profits and a rising share price was not through growth, but from cost-cutting and consolidation, as pursued by BAT, Imperial and AstraZeneca. A once promising pipeline of tech and biotech companies vanished.
As the ranks of UK companies thinned, they were replaced by companies with neither assets nor headquarters in the UK. At one point a decade ago, the FTSE 100 included 13 mining groups – not one of which had a single mine in the UK. Inevitably, most disappeared as metal prices crumbled, pulling down the index. Even now, the index includes companies such as Coca-Cola HBC, a Greek company headquartered in Switzerland. It may be a fine company – but what is it doing in the FTSE 100? It would be easy to assume, as the attendees at the JP Morgan Cazenove conference did, that there is no sign of an end to the remorseless decline of the UK stockmarket.
The turning point
But nothing could be further from the truth. While UK large caps have floundered, the small- and mid-cap sectors are in rude health. The FTSE 250 index, once similar numerically to the FTSE 100, now trades at nearly 19,000, where the FTSE 100 would be had it kept pace with the US market. These companies will slowly make their way into the FTSE 100, hopefully without picking up bad habits – such as excessive boardroom remuneration – along the way. While the UK has always had an excellent base in technology and medical sciences, it has been very poor at commercialising its inventions, selling out too early and suffering a brain drain to the US. Much of the strong performance of the US market is due to its record of building start-ups into giant companies, from Microsoft and Biogen, to Netflix, Facebook and many, many more. Very few companies in the FTSE 100 have done that. But, in time, that should change. There is growing confidence in the UK’s tech and medical sciences sectors: a growing number of investors are willing to provide the long-term capital that has been unavailable in the past, and there is a new determination not to sell out too soon.
Meanwhile, the mega-caps may be shaking off their torpor. The FTSE 100 returned 19% last year, 12% ahead of the FTSE 250, helped by good performances from HSBC, BP and Shell. That the new head of GlaxoSmithKline (which performed respectably well last year) will be paid less than her predecessor is encouraging. Tesco appears to be on the mend, Vodafone is paddling furiously and Rolls-Royce seems to be on the path to recovery. Bids for Unilever and AstraZeneca show that size is no longer a protection for complacent management, while companies are as ready to shrink their way to prosperity as to grow.
And while the sight of the FTSE 100 trading at all-time highs gives some investors vertigo, some indicators suggest it has much further to go. Professor Paul Marsh of the London Business School notes that the 11% return on the All-Share between the “Brexit” devaluation and January 2017, compares with 12 month-returns of 44%, 41% and 31% respectively following the 1967, 1992 and 2008 devaluations. The UK market may have adjusted for the benefit of translating foreign earnings into sterling, but not for the consequent profit margin or sales volume expansion, or for the indirect benefit to domestic companies from a reinvigorated export sector.
Now looks a good time to buy
Nick Moakes, investments partner at Wellcome Trust, has an intriguing chart. It goes back 300 years, and it shows the real (after-inflation) return an investor would have made on UK equities over ten years compared with that made over the previous ten years. In short, it shows that future returns are highest when past returns are lowest, and vice versa. In other words, investors are best off buying at a point when ten-year returns have been woeful. Given how low the past ten-year return sank in 2009/10, the pattern suggests there’s the potential for significant further real returns in the years ahead.
That’s not to say the UK is cheap. On a multiple of 14.7 times 2017 earnings – expected to grow by 21% this year – it is about 10% below the global average, but it’s close to the ratings of Europe and Japan. As a result, anything more than a modest market re-rating looks unlikely. However, in light of good economic growth, a rebound from weakness in profits in recent years, and the benefit of devaluation, earnings forecasts could prove too low. Moreover, as 2018 approaches, further double-digit growth in earnings should start to be factored in.
One of the best arguments in favour of the UK is the universality of pessimism on the outlook for both the economy and the market. Some of this is related to Brexit, but whether Brexit is negative or positive for the UK in the long or even the short run is something that nobody knows. Current pessimism discounts a very bad outcome – anything better than that should boost sentiment on the UK market. What we do know is that the economy is growing steadily.
Growth is currently expected to be more than 2% this year, but this will probably be revised higher. This, and the fall in sterling, should flow through into corporate earnings and increased investment. Before long the Bank of England will surely follow the Federal Reserve in raising interest rates, underpinning sterling. We also know that 65%-70% of FTSE 100 earnings derive from overseas, rather than being dependent on the UK.
So the pessimism on the UK may seem irrational, but the conference poll shows it to be real. At a panel session before the poll, investment managers lined up to assure the audience that they were selling out of the UK. A lone exception was Andrew Bell, CEO of Witan Investment Trust. Later he told me, “the exposure to the UK in our benchmark was reduced from 40% to 30% at the start of the year but our exposure is close to 40%. We see good long-term value… and are in no hurry to reduce exposure.” That was hardly a ringing endorsement, and Bell had clearly not picked the UK as his favoured region. I had – I just couldn’t get the voting technology to work. Being a bull of the UK market is a very lonely position – but that is a prerequisite of all great contrarian investments.
The UK-focused funds to buy now
The strong outperformance of medium and smaller-sized companies means that funds with high exposure to the UK have done well recently, while those that stuck to the FTSE 100, and especially to the dominant mega-caps, will have struggled to beat an exchange-traded fund or passive tracker fund. Fidelity Special Values (LSE: FSV) maintains the strong record built up by Anthony Bolton, having multiplied nearly 16-fold since 1994, but it has just 25% of its portfolio in the FTSE 100. Among open-ended funds, Old Mutual UK Alpha, run by Richard Buxton, has a strong record despite being 75%-80% invested in large caps. Fidelity UK Opportunities, managed by Leigh Himsworth, has also done well, but with a lesser focus on large caps.
In the UK equity income segment, City of London Trust (LSE: CTY), which Job Curtis has managed since 1991, has raised its dividend every year for the last 45 years. It has a solid total-return record, only held back by its high exposure to large caps, and yields nearly 4%. Perpetual Income & Growth (LSE: PLI), which is run by Mark Barnett, has a strong long-term record, but has been dull in the past year, while Temple Bar (LSE: TMPL), managed by Alastair Mundy, has, in the last year, caught up on a previous dull patch. Lowland (LSE: LWI), which has been managed by James Henderson since 1990, has a strong all-round record from a growth-orientated portfolio. Nick Train’s Finsbury Income & Growth (LSE: FGT) is classified as a UK trust, but has 18% of its portfolio overseas, while the UK stocks are strongly international. A focus on branded consumer goods and services with demonstrable longevity has been the basis of an outstanding performance record, but the investment thesis is steady growth, not recovery.
Independent Investment Trust (LSE: IIT) is notionally in the global sector, but 98% of its assets are in the UK. Manager Max Ward and chairman Douglas “frugal” McDougall own nearly 25% of the shares between them, which means the focus of this self-managed trust is very much on investor returns, which compare well with those of most global trusts, let alone with the UK specialists. Also in the global sector, Law Debenture (LSE: LWDB), which like Lowland is managed by James Henderson, is 74% invested in the UK, which includes the trust’s directly owned fiduciary services business. Witan (LSE: WTAN) has 39% of its assets in the UK and is a good choice for those who want a global fund with a UK bias.
Among the trusts restricted to the FTSE 250, JP Morgan Mid Cap Investment Trust (LSE: JMF), managed by Georgina Brittain, leads the field on long-term performance. Competition is tighter in the small cap arena, with BlackRock Smaller Companies (LSE: BRSC) and Henderson Smaller Companies (LSE: HSL) perhaps having the edge – but Aberforth Smaller Companies (LSE: ASL), as the sole value fund, is worth a look given that value investing seems to be returning to favour.